**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM10-Q/AAmendment No. 1**

 

**ý****          ****QuarterlyReport Pursuant to Section 13 or 15(d)of the Securities Exchange Act of 1934**

 

**For the quarterly period endedJune 30, 2005**

 

**or**

 

**o****          ****TransitionReport Pursuant to Section 13 or 15(d)of the Securities Exchange Act of 1934**

 

**For the transition periodfrom            to            **

 

**Commission File No. 0-20838**

 

**CLAYTON WILLIAMS ENERGY,INC.**

(Exact name of Registrant as specified in its charter)

 

| **Delaware**                                   | ** ** | **75-2396863**          |
|------------------------------------------------|------------|-------------------------|
| (State or other  jurisdiction of               |       | (I.R.S. Employer        |
| incorporation or  organization)                |       | Identification  Number) |
|                                           |       |                    |
| **6 Desta  Drive, Suite 6500, Midland, Texas** | ** ** | **79705-5510**          |
| (Address of  principal executive offices)      |       | (Zip code)              |

 

Registrant’s Telephone Number, including area code:**   (432) 682-6324**

 

| **Not  applicable**                                                                 |
|-------------------------------------------------------------------------------------|
| (Former name,  former address and former fiscal year, if changed since last report) |

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

Yes         ý            No           o

 

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Exchange Act Rule 12b-2).Yes         ý            No           o

 

There were 10,808,811 shares of Common Stock, $.10 par value, of theregistrant outstanding as of August 5, 2005.

 

 

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**EXPLANATORYNOTE**

 

This Amendment No. 1 on Form 10-Q/A to the Quarterly Report on Form10-Q for the period ended June 30, 2005 of Clayton Williams Energy, Inc.,initially filed with the Securities and Exchange Commission on August 9, 2005,is being filed to report Part II-Item 4, which was inadvertently omitted.  All other information in the quarterly reporton Form 10-Q remains unchanged from the original filing.

 

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**CLAYTON WILLIAMS ENERGY, INC.**

**TABLE OF CONTENTS**

 
|        | **PART  I.  FINANCIAL INFORMATION**                                                                |       |
|-------------|---------------------------------------------------------------------------------------------------------|------------|
|        |                                                                                                    |       |
| Item 1.     | Financial Statements                                                                                    |       |
|        |                                                                                                    |       |
|        | Consolidated Balance Sheets as of  June 30, 2005 and December 31, 2004                             |       |
|        |                                                                                                    |       |
|        | Consolidated Statements of  Operations for the three months and six months ended June 30, 2005 and 2004 |       |
|        |                                                                                                    |       |
|        | Consolidated  Statement of Stockholders’ Equity for the six months ended June 30, 2005             |       |
|        |                                                                                                    |       |
|        | Consolidated  Statements of Cash Flows for the six months ended June 30, 2005 and 2004                  |       |
|        |                                                                                                    |       |
|        | Notes  to Consolidated Financial Statements                                                             |       |
|        |                                                                                                    |       |
| Item  2.    | Management’s  Discussion and Analysis of Financial Condition and Results of Operations             |       |
|        |                                                                                                    |       |
| Item  3.    | Quantitative  and Qualitative Disclosure About Market Risks                                             |       |
|        |                                                                                                    |       |
| Item  4.    | Controls  and Procedures                                                                                |       |
|        |                                                                                                    |       |
| ** **  | **PART II. OTHER  INFORMATION**                                                                         | ** ** |
| ** **  | ** **                                                                                              | ** ** |
| **Item 4.** | **Submission of Matters to a  Vote of Security Holders**                                                | ** ** |
| ** **  | ** **                                                                                              | ** ** |
| Item  6.    | Exhibits                                                                                                |       |
|        |                                                                                                    |       |
|        | Signatures                                                                                              |       |

 

2

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**CLAYTON WILLIAMS ENERGY, INC.**

### **CONSOLIDATED BALANCE SHEETS**

**(Dollars in thousands)**

 
| ** **                                                                                                                                                           |       | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                           |       | **(Unaudited)**         |       |                        |       |
| **ASSETS**                                                                                                                                                           |       |                    |       |                        |       |
| CURRENT ASSETS                                                                                                                                                       |       |                    |       |                        |       |
| Cash and cash  equivalents                                                                                                                                           |       | $                       | 10,677     |                        | $          | 16,359 |   |
| Accounts  receivable:                                                                                                                                                |       |                    |       |                        |       |
| Oil and gas  sales, net                                                                                                                                              |       | 26,718                  |       | 25,573                      |       |
| Joint interest  and other, net                                                                                                                                       |       | 4,530                   |       | 4,653                       |       |
| Affiliates                                                                                                                                                           |       | 668                     |       | 553                         |       |
| Inventory                                                                                                                                                            |       | 13,482                  |       | 5,202                       |       |
| Deferred income  taxes                                                                                                                                               |       | 691                     |       | 625                         |       |
| Fair value of  derivatives                                                                                                                                           |       | 212                     |       | 2,333                       |       |
| Prepaids and  other                                                                                                                                                  |       | 2,951                   |       | 1,401                       |       |
|                                                                                                                                                                 |       | 59,929                  |       | 56,699                      |       |
| PROPERTY AND  EQUIPMENT                                                                                                                                              |       |                    |       |                        |       |
| Oil and gas  properties, successful efforts method                                                                                                                   |       | 953,009                 |       | 909,095                     |       |
| Natural gas  gathering and processing systems                                                                                                                        |       | 17,448                  |       | 17,286                      |       |
| Other                                                                                                                                                                |       | 11,919                  |       | 11,839                      |       |
|                                                                                                                                                                 |       | 982,376                 |       | 938,220                     |       |
| Less accumulated  depreciation, depletion and amortization                                                                                                           |       | (555,140                | )          | (539,860                    | )          |
| Property and  equipment, net                                                                                                                                         |       | 427,236                 |       | 398,360                     |       |
|                                                                                                                                                                 |       |                    |       |                        |       |
| OTHER ASSETS                                                                                                                                                         |       | 6,978                   |       | 7,176                       |       |
|                                                                                                                                                                 |       | $                       | 494,143    |                        | $          | 462,235 |   |
| ** **                                                                                                                                                           | ** ** | ** **              | ** ** | ** **                  | ** ** |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                       | ** ** | ** **              | ** ** | ** **                  | ** ** |
| CURRENT  LIABILITIES                                                                                                                                                 |       |                    |       |                        |       |
| Accounts  payable:                                                                                                                                                   |       |                    |       |                        |       |
| Trade                                                                                                                                                                |       | $                       | 37,284     |                        | $          | 51,014 |   |
| Oil and gas  sales                                                                                                                                                   |       | 10,238                  |       | 11,223                      |       |
| Affiliates                                                                                                                                                           |       | 2,386                   |       | 2,954                       |       |
| Current  maturities of long-term debt                                                                                                                                |       | 27                      |       | 31                          |       |
| Fair value of  derivatives                                                                                                                                           |       | 27,779                  |       | 16,026                      |       |
| Accrued  liabilities and other                                                                                                                                       |       | 3,103                   |       | 3,017                       |       |
|                                                                                                                                                                 |       | 80,817                  |       | 84,265                      |       |
| NON-CURRENT  LIABILITIES                                                                                                                                             |       |                    |       |                        |       |
| Long-term debt                                                                                                                                                       |       | 189,607                 |       | 177,519                     |       |
| Deferred income  taxes                                                                                                                                               |       | 36,911                  |       | 36,897                      |       |
| Fair value of  derivatives                                                                                                                                           |       | 50,305                  |       | 28,958                      |       |
| Other                                                                                                                                                                |       | 17,487                  |       | 17,000                      |       |
|                                                                                                                                                                 |       | 294,310                 |       | 260,374                     |       |
| COMMITMENTS AND  CONTINGENCIES                                                                                                                                       |       |                    |       |                        |       |
|                                                                                                                                                                 |       |                    |       |                        |       |
| STOCKHOLDERS’  EQUITY                                                                                                                                           |       |                    |       |                        |       |
| Preferred stock,  par value $.10 per share, authorized – 3,000,000 shares; issued and  outstanding – none                                                  |       | —                  |       | —                      |       |
| Common stock,  par value $.10 per share, authorized – 30,000,000 shares; issued and  outstanding – 10,805,445 shares in 2005 and 10,787,013 shares in 2004 |       | 1,080                   |       | 1,078                       |       |
| Additional  paid-in capital                                                                                                                                          |       | 105,134                 |       | 104,674                     |       |
| Retained  earnings                                                                                                                                                   |       | 12,802                  |       | 11,844                      |       |
|                                                                                                                                                                 |       | 119,016                 |       | 117,596                     |       |
|                                                                                                                                                                 |       | $                       | 494,143    |                        | $          | 462,235 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

3

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**CLAYTON WILLIAMS ENERGY, INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Unaudited)**

**(In thousands, except per share)**

 
| ** **                                   | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                   | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| REVENUES                                     |       |                                  |       |                                |       |   |   |   |   |
| Oil and gas  sales                           |       | $                                     | 63,301     |                                | $          | 41,119 |   | $ | 124,797 |   | $ | 77,451 |   |
| Natural gas  services                        |       | 2,550                                 |       | 2,372                               |       | 5,131 |   | 4,899 |   |
| Gain on sales of  property and equipment     |       | 467                                   |       | 61                                  |       | 2,079 |   | 66 |   |
| Total revenues                               |       | 66,318                                |       | 43,552                              |       | 132,007 |   | 82,416 |   |
|                                         |       |                                  |       |                                |       |   |   |   |   |
| COSTS AND  EXPENSES                          |       |                                  |       |                                |       |   |   |   |   |
| Production                                   |       | 13,856                                |       | 8,175                               |       | 26,427 |   | 15,130 |   |
| Exploration:                                 |       |                                  |       |                                |       |   |   |   |   |
| Abandonments and  impairments                |       | 6,430                                 |       | 13,467                              |       | 17,700 |   | 18,099 |   |
| Seismic and  other                           |       | 1,665                                 |       | 1,812                               |       | 2,453 |   | 3,737 |   |
| Natural gas  services                        |       | 2,374                                 |       | 2,295                               |       | 4,791 |   | 4,647 |   |
| Depreciation,  depletion and amortization    |       | 12,288                                |       | 9,247                               |       | 24,580 |   | 17,771 |   |
| Accretion of  abandonment obligations        |       | 288                                   |       | 265                                 |       | 567 |   | 440 |   |
| General and  administrative                  |       | 3,134                                 |       | 2,286                               |       | 5,652 |   | 5,587 |   |
| Loss on sales of  property and equipment     |       | —                                |       | —                              |       | 32 |   | — |   |
| Total costs and  expenses                    |       | 40,035                                |       | 37,547                              |       | 82,202 |   | 65,411 |   |
| Operating income                             |       | 26,283                                |       | 6,005                               |       | 49,805 |   | 17,005 |   |
| OTHER INCOME  (EXPENSE)                      |       |                                  |       |                                |       |   |   |   |   |
| Interest expense                             |       | (2,566                                | )          | (1,449                              | )          | (4,932 | ) | (1,909 | ) |
| Change in fair  value of derivatives         |       | (9,837                                | )          | (309                                | )          | (44,926 | ) | (3,402 | ) |
| Other                                        |       | 650                                   |       | 87                                  |       | 1,096 |   | (37 | ) |
| Total other  income (expense)                |       | (11,753                               | )          | (1,671                              | )          | (48,762 | ) | (5,348 | ) |
|                                         |       |                                  |       |                                |       |   |   |   |   |
| Income before  income taxes                  |       | 14,530                                |       | 4,334                               |       | 1,043 |   | 11,657 |   |
| Income tax  expense                          |       | 4,580                                 |       | 1,465                               |       | 85 |   | 3,975 |   |
| NET INCOME                                   |       | $                                     | 9,950      |                                | $          | 2,869 |   | $ | 958 |   | $ | 7,682 |   |
| Net income per  common share:                |       |                                  |       |                                |       |   |   |   |   |
| Basic                                        |       | $                                     | 0.92       |                                | $          | 0.29 |   | $ | 0.09 |   | $ | 0.80 |   |
| Diluted                                      |       | $                                     | 0.90       |                                | $          | 0.28 |   | $ | 0.09 |   | $ | 0.77 |   |
|                                         |       |                                  |       |                                |       |   |   |   |   |
| Weighted average  common shares outstanding: |       |                                  |       |                                |       |   |   |   |   |
| Basic                                        |       | 10,800                                |       | 9,923                               |       | 10,796 |   | 9,647 |   |
| Diluted                                      |       | 11,089                                |       | 10,230                              |       | 11,068 |   | 9,958 |   |
|                                              |            |                                       |            |                                     |            |  |  |  |  |  |  |  |  |  |  |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

4

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**CLAYTON WILLIAMS ENERGY, INC.**

**CONSOLIDATEDSTATEMENT OF STOCKHOLDERS’ EQUITY**

**(Unaudited)**

**(In thousands)**

 
| ** **                                    | ** ** | **Common Stock**          | ** ** | **Additional**   | ** ** | ** **             | ** ** |
|-----------------------------------------------|------------|---------------------------|------------|------------------|------------|------------------------|------------|
| ** **                                    | ** ** | **No. of****Shares** | ** ** | **Par****Value** | ** ** | **Paid-In****Capital** | ** ** | **Retained****Earnings** | ** ** |
| BALANCE,                                      |       |                      |       |             |       |                   |       |   |   |
| December 31,  2004                       |       | 10,787                    |       | $                | 1,078      |                   | $          | 104,674 |   | $ | 11,844 |   |
| Net income and  total comprehensive income    |       | —                    |       | —           |       | —                 |       | 958 |   |
| Issuance of  stock through compensation plans |       | 18                        |       | 2                |       | 460                    |       | — |   |
| BALANCE,                                      |       |                      |       |             |       |                   |       |   |   |
| June 30,  2005                           |       | 10,805                    |       | $                | 1,080      |                   | $          | 105,134 |   | $ | 12,802 |   |
|                                               |            |                           |            |                  |            |                        |            |  |  |  |  |  |  |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

5

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**CLAYTON WILLIAMS ENERGY, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Unaudited)**

**(In thousands)**

 
| ** **                                                                     | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                     | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES                                          |       |                                |       |   |   |
| Net income                                                                     |       | $                                   | 958        |   | $ | 7,682 |   |
| Adjustments to  reconcile net income to cash provided by operating activities: |       |                                |       |   |   |
| Depreciation,  depletion and amortization                                      |       | 24,580                              |       | 17,771 |   |
| Exploration  costs                                                             |       | 17,700                              |       | 18,099 |   |
| Gain on sales of  property and equipment                                       |       | (2,047                              | )          | (66 | ) |
| Deferred income  taxes                                                         |       | (44                                 | )          | 3,975 |   |
| Non-cash  employee compensation                                                |       | 720                                 |       | 156 |   |
| Change in fair  value of derivatives                                           |       | 35,221                              |       | 437 |   |
| Settlements on  derivatives with financing elements                            |       | 9,796                               |       | — |   |
| Accretion of  abandonment obligations                                          |       | 567                                 |       | 440 |   |
| Changes in  operating working capital:                                         |       |                                |       |   |   |
| Accounts  receivable                                                           |       | (1,137                              | )          | 5,067 |   |
| Accounts payable                                                               |       | (8,827                              | )          | (255 | ) |
| Other                                                                          |       | (8,205                              | )          | (3,907 | ) |
| Net cash  provided by operating activities                                     |       | 69,282                              |       | 49,399 |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES                                          | ** ** | ** **                          | ** ** | ** ** | ** ** |
| Additions to  property and equipment                                           |       | (79,001                             | )          | (66,099 | ) |
| Investment in  Southwest Royalties, Inc.                                  |       | —                              |       | (167,841 | ) |
| Proceeds from  sales of property and equipment                                 |       | 2,151                               |       | 437 |   |
| Other                                                                          |       | (418                                | )          | 103 |   |
| Net cash used in  investing activities                                         |       | (77,268                             | )          | (233,400 | ) |
| CASH FLOWS FROM  FINANCING ACTIVITIES                                          | ** ** | ** **                          | ** ** | ** ** | ** ** |
| Proceeds from  long-term debt                                                  |       | 12,100                              |       | 186,662 |   |
| Repayments of  long-term debt                                                  |       | —                              |       | (25,000 | ) |
| Proceeds from  sale of common stock                                            |       | —                              |       | 30,003 |   |
| Settlements on  derivatives with financing elements                            |       | (9,796                              | )          | — |   |
| Payment of debt  issue costs                                                   |       | —                              |       | (4,156 | ) |
| Net cash  provided by financing elements                                       |       | 2,304                               |       | 187,509 |   |
| NET INCREASE  (DECREASE) IN CASH AND CASH EQUIVALENTS                          |       | (5,682                              | )          | 3,508 |   |
| CASH AND CASH  EQUIVALENTS                                                     |       |                                |       |   |   |
| Beginning of  period                                                           |       | 16,359                              |       | 15,454 |   |
| End of period                                                                  |       | $                                   | 10,677     |   | $ | 18,962 |   |
| SUPPLEMENTAL  DISCLOSURES                                                      |       |                                |       |   |   |
| Cash paid for  interest, net of amounts capitalized                            |       | $                                   | 5,343      |   | $ | 1,631 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

6

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**CLAYTONWILLIAMS ENERGY, INC.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**June 30, 2005**

**(Unaudited)**

 

**1.****             Natureof Operations**

 

ClaytonWilliams Energy, Inc. (a Delaware corporation) and its subsidiaries(collectively, the “Company” or “CWEI”) is an independent oil and gas companyengaged in the exploration for and development and production of oil andnatural gas primarily in its core areas in Texas, Louisiana and NewMexico.  Approximately 42% of the Company’soutstanding common stock is beneficially owned by its Chairman of the Board andChief Executive Officer, Clayton W. Williams (“Mr. Williams”).  Oil and gas exploration and production is theonly business segment in which the Company operates.

 

Substantiallyall of the Company’s oil and gas production is sold under short-term contractswhich are market-sensitive.  Accordingly,the Company’s financial condition, results of operations, and capital resourcesare highly dependent upon prevailing market prices of, and demand for, oil andnatural gas.  These commodity prices aresubject to wide fluctuations and market uncertainties due to a variety offactors that are beyond the control of the Company.  These factors include the level of global demandfor petroleum products, foreign supply of oil and gas, the establishment of andcompliance with production quotas by oil-exporting countries, weatherconditions, the price and availability of alternative fuels, and overalleconomic conditions, both foreign and domestic.

 

**2.****            ****Presentation**

 

Thepreparation of these consolidated financial statements in conformity withaccounting principles generally accepted in the United States requiresmanagement of the Company to make estimates and assumptions that affect thereported amounts of assets and liabilities and disclosure of contingent assetsand liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting periods.  Actual results could differ materially fromthose estimates.

 

In theopinion of management, the Company’s unaudited consolidated financialstatements as of June 30, 2005 and for the interim periods ended June 30,2005 and 2004 include all adjustments which are necessary for a fair presentationin accordance with accounting principles generally accepted in the UnitedStates.  These interim results are notnecessarily indicative of the results to be expected for the year ending December 31,2005.

 

Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with accounting principles generally accepted in theUnited States have been condensed or omitted in this Form 10-Qpursuant to the rules and regulations of the Securities and Exchange Commission(“SEC”).  These consolidated financialstatements should be read in conjunction with the audited consolidatedfinancial statements and notes thereto included in the Company’s 2004 Form 10-K.

 

**3.****             RecentAccounting Pronouncements**

 

InEITF 04-5 the Emerging Issues Task Force (“EITF”) has reachedconsensus regarding when a limited partnership should be consolidated by itsgeneral partner.  The proposed frameworkpresumes that a sole general partner in a limited partnership controls thelimited partnership.  The presumption ofcontrol can be overcome if the limited partners have (i) the substantiveability to remove the sole general partner or otherwise dissolve the limitedpartnership or (ii) substantive participating rights.  The EITF has concluded

 

7

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that a general partner lacks control if the limited partners can removethe general partner with a simple majority vote.  The Company is the general partner of severaloil and gas limited partnerships and presently consolidates its proportionateinterest in the accounts of these partnerships. The Company is currently reviewing the applicable provisions of thepartnership agreements to determine the impact that EITF 04-5 mayhave on its consolidated financial statements. For existing partnerships, EITF 04-5 will be effective forconsolidated financial statements issued by the Company after January 1,2006.  EITF 04-5 is effective fornewly created or modified limited partnerships subsequent to June 29,2005.

 

In December 2004,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards No. 153 “Exchanges of Nonmonetary Assets, anamendment of APB Opinion No. 29” (“SFAS 153”).  SFAS 153 specifies the criteria requiredto record a nonmonetary asset exchange using carryover basis.  SFAS 153 is effective for nonmonetaryasset exchanges occurring after July 1, 2005.  The Company will adopt this statement in thethird quarter of 2005, and it is not expected to have a material effect on thefinancial statements when adopted.

 

In December 2004,the FASB issued Statement of Financial Accounting Standards No. 123(revised 2004) “Share-Based Payments” (“SFAS 123R”).  SFAS 123R requires that the cost fromall share-based payment transactions, including stock options, be recognized inthe financial statements at fair value. The Company currently uses the intrinsic-value method to account forthese share-based payments.  For publiccompanies, SFAS 123R is effective for fiscal years beginning after June 15,2005.  The Company will adopt theprovisions of this statement in the first quarter of 2006 and is currentlyassessing the effect of SFAS 123R on the financial statements.

 

In April 2005,the FASB issued Staff Position No. 19-1 (“FSP 19-1”).  FSP 19-1 amends the presentguidance in SFAS 19, paragraphs 31 and 34, regarding when exploratorydrilling costs pending determination of proved reserves can be carried as anasset of an oil and gas company that uses the successful efforts accountingmethod.  The Company is required to adoptFSP 19-1, including its disclosures, on July 1, 2005.  Based on the Company’s present understandingof this staff position, the adoption of FSP 19-1 will not have asignificant impact on the Company’s results of operations.  At June 30, 2005 and December 31,2004, the Company had capitalized $0 and $5.4 million, respectively, ofexploratory drilling costs applicable to wells that were pending determinationof proved reserves.  Substantially all ofthe December 31, 2004 capitalized cost was subsequently classified asnon-productive.

 

**4.****             Acquisitionof Southwest Royalties, Inc.**

 

On May 21,2004, the Company acquired all the outstanding common stock of SouthwestRoyalties, Inc. (“SWR”) through a merger. Prior to the acquisition, SWR was a privately-held, Midland-based energycompany engaged in oil and gas exploration, production, development andacquisition activities in the United States. Most of SWR’s properties are located in the Permian Basin of west Texasand southeastern New Mexico.

 

Inconnection with the acquisition of SWR, the Company paid $57.1 million toholders of SWR common stock and common stock warrants and assumed andrefinanced approximately $113.9 million of SWR bank debt at closing.  In addition, the Company incurredapproximately $9.4 million of merger-related costs, including (i) theassumption of SWR’s obligations to its officers and employees pursuant tochange of control arrangements and (ii) investment banking, legal,accounting and other direct transaction costs related to the acquisition ofSWR.

 

TheCompany has accounted for the acquisition of SWR using the purchase method ofaccounting for business combinations. Under this method of accounting, CWEI is deemed to be the acquirer for

 

8

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accounting purposes.  SWR’sassets and liabilities were revalued under the purchase method of accountingand recorded at their estimated fair values.

 

Thefollowing table reflects the unaudited pro forma results of operations for the sixmonths ended June 30, 2004 as though the acquisition of SWR had occurredon January 1, 2004.  The pro formaamounts are not necessarily indicative of the results that may be reported inthe future.

 
| ** **                                      | ** ** | **Six Months Ended**      | ** ** |
|-------------------------------------------------|------------|---------------------------|------------|
| ** **                                      | ** ** | **June 30, 2004**    | ** ** |
| ** **                                      | ** ** | **(In thousands, except** | ** ** |
| ** **                                      | ** ** | **per share data)**       | ** ** |
| Revenues                                        |       | $                         | 106,248    |   |
| Net loss from  continuing operations            |       | $                         | (3,705     | ) |
|                                            |       |                      |       |
| Net loss from  continuing operations per share: |       |                      |       |
| Basic                                           |       | $                         | (.33       | ) |
| Diluted                                         |       | $                         | (.33       | ) |

 

**5.****             Long-TermDebt**

 

Long-termdebt consists of the following:

 
| ** **                           | ** ** | **June 30,**  | ** ** | **December 31,** | ** ** |
|--------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                           | ** ** | **2005**           | ** ** | **2004**              | ** ** |
| ** **                           | ** ** | **(In thousands)** | ** ** |
| Secured bank  credit facilities:     |       |               |       |                  |       |
| Revolving loan,  due May 2007   |       | $                  | 159,600    |                  | $          | 147,500 |   |
| Senior term  loan, due May 2008 |       | 30,000             |       | 30,000                |       |
| Other                                |       | 34                 |       | 50                    |       |
|                                 |       | 189,634            |       | 177,550               |       |
| Less current  maturities             |       | (27                | )          | (31                   | )          |
|                                 |       | $                  | 189,607    |                  | $          | 177,519 |   |

 

Subsequent to June 30, 2005, the Company repaid all amountsoutstanding under the secured bank credit facilities with proceeds from aprivate placement of senior notes (see “73⁄4% Senior Notes due 2013”).

 

*SecuredBank Credit Facilities*

In connection with the acquisition of SWR in May 2004 (seeNote 4), the Company entered into new credit facilities with a group ofbanks that provided for an increase in borrowing capacity under the Company’sexisting revolving credit facility and established a new senior term creditfacility.  The borrowing base establishedunder the revolving credit facility increased from $95 million to $180 million,and the Company initially borrowed $75 million on the senior term creditfacility.  With a portion of the netproceeds from the private placement of common stock in May 2004 (seeNote 7), the Company reduced the principal balance on the senior termcredit facility to $50 million.  In November 2004,the banks increased the borrowing base under the revolving credit facility to$195 million, and the Company paid down the senior term credit facility to$30 million with proceeds from certain asset sales.

 

The revolving credit facility provides for interest at rates based on theagent bank’s prime rate plus margins ranging from .25% to 1%, or if elected bythe Company based on LIBOR plus margins ranging

 

9

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from 1.5% to 2.25%.  The Company also pays a commitment fee on theunused portion of the revolving credit facility.  Initially, the senior term credit facilityprovided for interest at rates based on the agent bank’s prime rate plus amargin of 3.5%, or if elected by the Company based on LIBOR plus a marginof 5%.  Subsequently, the prime ratemargin was reduced to 2.5%, and the LIBOR margin was reduced to 4%.  Interest and fees are payable at leastquarterly.  The effective annual interestrate on the combined credit facility, including bank fees and amortization ofdebt issue costs, for the six months ended June 30, 2005 was 6.1%.

 

The amount of funds available to the Company under the revolving creditfacility is the lesser of the borrowing base, as established by the banks, orthat portion of the borrowing base determined by the Company to be the electedborrowing limit.  The borrowing base,which is based on the discounted present value of future net revenues from oiland gas production, is subject to redetermination at any time, but at leastsemi-annually in May and November, and is made at the discretion of thebanks.  At June 30, 2005, theborrowing base was $195 million, with no monthly commitmentreductions.  In connection with theissuance of the 73⁄4% Senior Notes due 2013 in July 2005, the borrowing basewas reduced to $132.5 million, and all outstanding balances on therevolving credit facility were repaid.

 

The loan agreement applicable to the revolving credit facility containsfinancial covenants that are computed quarterly.  The working capital covenant requires theCompany to maintain a ratio of current assets to current liabilities of atleast 1 to 1.  Another financial covenantunder the credit facility requires the Company to maintain a ratio ofindebtedness to cash flow of no more than 3 to 1.  The computations of current assets, currentliabilities, cash flow and indebtedness are defined in the loan agreement.  The Company was in compliance with allfinancial and non-financial covenants at June 30, 2005.

 

*73⁄4% Senior Notes due 2013*

In July 2005, the Company issued, in a private placement,$225 million of aggregate principal amount of 73⁄4% Senior Notes due 2013 (“SeniorNotes”).  The Senior Notes were issued atface value and will bear interest at 73⁄4% per year, payable semi-annually on February 1and August 1 of each year, beginning February 1, 2006.  After the payment of typical transactionexpenses, net proceeds of approximately $217 million were used to repayamounts outstanding on the Company’s secured credit facilities and for generalcorporate purposes, including the funding of planned exploration anddevelopment activities.

 

At any time prior to August 1, 2008, the Company may redeem up to 35%of the aggregate principal amount of the Senior Notes with the proceeds ofcertain equity offerings at a redemption price of 107.75% of the principalamount, plus accrued and unpaid interest. In addition, prior to August 1, 2009, the Company may redeem someor all of the Senior Notes at a redemption price equal to 100% of the principalamount of the Senior Notes to be redeemed, plus a make-whole premium, plus anyaccrued and unpaid interest.  On andafter August 1, 2009, the Company may redeem some or all of the SeniorNotes at redemption prices (expressed as percentages of principal amount) equalto 103.875% for the twelve-month period beginning on August 1, 2009, 101.938%for the twelve-month period beginning on August 1, 2010, and 100.00%beginning on August 1, 2011, for any period thereafter, in each case plusaccrued and unpaid interest.

 

The Indenture governing the Senior Notes restricts the ability of theCompany and its restricted subsidiaries to: (i) borrow money; (ii) issue redeemable and preferred stock; (iii) paydistributions or dividends; (iv) make investments; (v) create lienswithout securing the Notes; (vi) enter into agreements that restrictdividends from subsidiaries; (vii) sell certain assets or merge with orinto other companies; (viii) enter into transactions with affiliates; (ix) guaranteeindebtedness; and (x) enter into new lines of business.  These covenants are subject to a number ofimportant exceptions and qualifications.

 

10

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**6.****             Other Non-Current Liabilities**

 

Other non-current liabilities consist of the following:

 
| ** **               | ** ** | **June 30,**  | ** ** | **December 31,** | ** ** |
|--------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **               | ** ** | **2005**           | ** ** | **2004**              | ** ** |
| ** **               | ** ** | **(In thousands)** | ** ** |
| Abandonment  obligations |       | $                  | 16,671     |                  | $          | 16,147 |   |
| Other                    |       | 816                |       | 853                   |       |
|                     |       | $                  | 17,487     |                  | $          | 17,000 |   |

 

Changes in abandonmentobligations for the six months ended June 30, 2005 and 2004 are asfollows:

 
| ** **                                                                            | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                            | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| ** **                                                                            | ** ** | **(In thousands)**                  | ** ** |
| Beginning of  period                                                                  |       | $                                   | 16,147     |   | $ | 8,849 |   |
| Abandonment  obligations related to the acquisition of Southwest Royalties, Inc. |       | —                              |       | 8,512 |   |
| Additional  abandonment obligations from new wells                                    |       | 236                                 |       | 64 |   |
| Sales or  abandonments of properties                                                  |       | (279                                | )          | (167 | ) |
| Accretion  expense                                                                    |       | 567                                 |       | 440 |   |
| End of period                                                                         |       | $                                   | 16,671     |   | $ | 17,698 |   |

 

**7.****             Common Stock**

 

In May 2004, theCompany sold 1,380,869 shares of its common stock to certain institutionalinvestors at a price of $23.00 per share in a private placement that raisedapproximately $31.8 million in gross proceeds. After the payment of typical transaction expenses, net proceeds ofapproximately $30 million were used to repay a portion of the bankindebtedness incurred to finance the acquisition of SWR (see Note 4).

 

**8.****         CompensationPlans**

 

*Executive Stock Compensation Plan*

TheCompany has a compensation plan which permits the Company to pay all or part ofselected executives’ salaries and bonuses in shares of common stock in lieu ofcash.  The Company reserved an aggregateof 500,000 shares of common stock for issuance under this plan.  During the six months ended June 30,2005, the Company issued 8,817 shares of common stock to Mr. Williams inlieu of net cash compensation aggregating $228,000, which is included ingeneral and administrative expenses in the accompanying consolidated financialstatements.  Subsequent to June 30,2005, the Company issued an additional 1,127 shares to Mr. Williams inlieu of cash compensation aggregating $39,000.

 

*Stock-Based Compensation*

In June 2005, Mr. Williamswas granted options to purchase 200,000 shares of common stock at a price of$29.39 per share, which was the market value at the date of grant.  The Company accounts for stock-based compensationutilizing the intrinsic value method prescribed by Accounting Principles BoardOpinion No. 25 “Accounting for Stock Issued to Employees” (“APB 25”)and related interpretations.  The

 

11

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following pro forma information, as required by Statement ofFinancial Accounting Standards No. 123 “Accounting for Stock-BasedCompensation” (“SFAS 123”), as amended by Statement of FinancialAccounting Standards No. 148 (“SFAS 148”), presents net income andearnings per share information as if the stock options issued since December 31,1994 were accounted for using the fair value method.  The fair value of stock options issued foreach year was estimated at the date of grant using the Black-Scholes optionpricing model.

 

The SFAS 123 pro formainformation for the six months ended June 30, 2005 and 2004 is as follows:

 
| ** **                                                                                                          | ** ** | **Six Months Ended  June 30,**  | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                                          | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| ** **                                                                                                          | ** ** | **(In thousands, except per share)** | ** ** |
| Net income  (loss), as reported                                                                                     |       | $                                    | 958        |   | $ | 7,682 |   |
| Add: Stock-based  employee compensation expense (credit) included in net income, net of tax                         |       | 182                                  |       | (133 | ) |
| Deduct:  Stock-based employee compensation expense determined under fair value based  method (SFAS 123), net of tax |       | (2,920                               | )          | — |   |
| Net income  (loss), pro forma                                                                                       |       | $                                    | (1,780     | ) | $ | 7,549 |   |
| Basic:                                                                                                              |       |                                 |       |   |   |
| Net income  (loss) per common share, as reported                                                                    |       | $                                    | .09        |   | $ | .80 |   |
| Net income  (loss) per common share, pro forma                                                                      |       | $                                    | (.16       | ) | $ | .78 |   |
| Diluted:                                                                                                            |       |                                 |       |   |   |
| Net income  (loss) per common share, as reported                                                                    |       | $                                    | .09        |   | $ | .77 |   |
| Net income (loss)  per common share, pro forma                                                                      |       | $                                    | (.16       | ) | $ | .76 |   |

 

In accordance with theissuance of Financial Accounting Standards Board Interpretation No. 44 (“FIN 44”)to APB 25, the Company changed the classification of 233,141 stock optionsrepriced in April 1999 from fixed stock options to variable stockoptions.  The Company is required torecognize compensation expense on the repriced options to the extent that thequoted market value of the Company’s common stock at the end of each periodafter July 1, 2000 exceeds the amended option price ($5.50 per share),except that options vested as of July 1, 2000 must recognize compensationexpense only to the extent that the quoted market value exceeds the marketvalue on that date ($31.94 per share). As the repriced options are exercised, the cumulative amount of accruedcompensation expense will be credited to additional paid-in capital.  Since this provision is based on changes inthe quoted market value of the Company’s common stock, the Company’s futureresults of operations may be subject to significant volatility.  Accrued compensation expense at June 30,2005 and December 31, 2004 is classified as a current liability in theaccompanying consolidated balance sheet and is comprised of the followingactivity for the periods then ended.

 
| ** **                                                                                   | ** ** | **June 30,**  | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                   | ** ** | **2005**           | ** ** | **2004**              | ** ** |
| ** **                                                                                   | ** ** | **(In thousands)** | ** ** |
| Beginning of  period                                                                         |       | $                  | 685        |                  | $          | 958 |   |
| Compensation  expense (credit)                                                               |       | 280                |       | (245                  | )          |
| Amounts  reclassified to additional paid-in capital for options exercised during the  period |       | (14                | )          | (28                   | )          |
| End of period                                                                                |       | $                  | 951        |                  | $          | 685 |   |

 

12

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*After-PayoutWorking Interest Incentive Plans*

In September 2002,the Compensation Committee of the Board of Directors adopted an incentive planfor officers, key employees and consultants, excluding Mr. Williams, whopromote the Company’s drilling and acquisition programs.  Management’s objective in adopting this planis to further align the interests of the participants with those of the Companyby granting the participants an after-payout working interest in the productiondeveloped, directly or indirectly, by the participants.  The plan provides for the creation of aseries of limited partnerships to which the Company, as general partner,contributes a portion of its working interest in wells drilled within certainareas, and the key employee and consultants, as limited partners, contributecash.  The Company pays all costs andreceives all revenues until payout of its costs, plus interest.  At payout, the limited partners receive 99%of all subsequent revenues and pay 99% of all subsequent expenses attributableto the partnerships’ interests.

 

Between 3% and 6% of theCompany’s working interests in substantially all wells drilled by the Companysubsequent to October 2002 are subject to this arrangement.  The Company consolidates its proportionateshare of partnership assets, liabilities, revenues, expenses and oil and gasreserves in its consolidated financial statements.  In April 2004, one of the partnershipsachieved payout, and the Company’s interest in the partnership was reduced to1%.  Aggregate cash distributions of $128,000were paid to the limited partners of this partnership during the six monthsended June 30, 2005.

 

**9.****             Derivatives**

 

# ***Commodity Derivatives***

From time to time, theCompany utilizes commodity derivatives, consisting of swaps, floors andcollars, to attempt to optimize the price received for its oil and gasproduction.  When using swaps to hedgeoil and natural gas production, the Company receives a fixed price for therespective commodity and pays a floating market price as defined in eachcontract (generally NYMEX futures prices), resulting in a net amount due to orfrom the counterparty.  When purchasingfloors, the Company receives a fixed price (put strike price) if the marketprice falls below the put strike price for the respective commodity.  If the market price is greater than the putstrike price, no payments are due from either party.  Costless collars are a combination of putsand calls, and contain a fixed floor price (put strike price) and ceiling price(call strike price).  If the market pricefor the respective commodity exceeds the call strike price or falls below theput strike price, then the Company receives the fixed price and pays the marketprice.  If the market price is betweenthe call and the put strike prices, no payments are due from either party.

 

The following summarizesinformation concerning the Company’s net positions in open commodityderivatives applicable to periods subsequent to June 30, 2005.  The settlement prices of commodityderivatives are based on NYMEX futures prices.

 

**Floors:**

** **
| ** **          | ** ** | **Gas**   | ** ** | **Oil**   | ** ** |
|---------------------|------------|-----------|------------|-----------|------------|
| ** **          | ** ** | **MMBtu** | ** ** | **Floor** | ** ** | **Bbls** | ** ** | **Floor** | ** ** |
| Production  Period: |       |      |       |      |       |   |   |   |   |
| 3rd Quarter 2005    |       | 1,840,000 |       | $         | 4.50       |   | 119,600 |   | $ | 28.00 |   |
| 4th Quarter 2005    |       | 1,840,000 |       | $         | 4.50       |   | 119,600 |   | $ | 28.00 |   |
|                |       | 3,680,000 |       |      |       | 239,200 |   |   |   |

 

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**Collars:**

** **
| ** **          | ** ** | **Gas**       | ** ** | **Oil**   | ** ** |
|---------------------|------------|---------------|------------|-----------|------------|
| ** **          | ** ** | **MMBtu (a)** | ** ** | **Floor** | ** ** | **Ceiling** | ** ** | **Bbls** | ** ** | **Floor** | ** ** | **Ceiling** | ** ** |
| Production  Period: |       |          |       |      |       |   |   |   |   |   |   |   |   |
| 3rd Quarter 2005    |       | 607,000       |       | $         | 4.00       |   | $ | 5.23 |   | 165,000 |   | $ | 23.00 |   | $ | 25.41 |   |
| 4th Quarter 2005    |       | 588,000       |       | $         | 4.00       |   | $ | 5.23 |   | 162,000 |   | $ | 23.00 |   | $ | 25.41 |   |
| 2006                |       | 2,024,000     |       | $         | 4.00       |   | $ | 5.21 |   | 613,000 |   | $ | 23.00 |   | $ | 25.32 |   |
| 2007                |       | 1,831,000     |       | $         | 4.00       |   | $ | 5.18 |   | 562,000 |   | $ | 23.00 |   | $ | 25.20 |   |
| 2008                |       | 1,279,000     |       | $         | 4.00       |   | $ | 5.15 |   | 392,000 |   | $ | 23.00 |   | $ | 25.07 |   |
|                |       | 6,329,000     |       |      |       |   |   | 1,894,000 |   |   |   |   |   |

 

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(a)           OneMMBtu equals one Mcf at a Btu factor of 1,000.

 

The following summarizes information concerning ournet positions in open interest rate swaps applicable to periods subsequent to June 30,2005.

 

**Interest Swaps:**

** **
| ** **                                      | ** ** | **Principal** | ** ** | **Libor** | ** ** |
|-------------------------------------------------|------------|---------------|------------|-----------|------------|
| ** **                                      | ** ** | **Balance**   | ** ** | **Rates** | ** ** |
| Period:                                         |       |          |       |      |       |
| July 1,  2005 to November 1, 2005     |       | $             | 60,000,000 |      | 2.97       | % |
| November 1,  2005 to November 1, 2006 |       | $             | 55,000,000 |      | 4.29       | % |
| November 1,  2006 to November 1, 2007 |       | $             | 50,000,000 |      | 5.19       | % |
| November 1,  2007 to November 1, 2008 |       | $             | 45,000,000 |      | 5.73       | % |

 

*AccountingFor Derivatives*

TheCompany accounts for its derivatives in accordance with Statement of FinancialAccounting Standards No. 133 “Accounting for Derivative Instruments andHedging Activities” (“SFAS 133”), as amended.  The Company did not designate any of itscurrently open commodity or interest rate derivatives as cash flow hedges;therefore, all changes in the fair value of these contracts prior to maturity,plus any realized gains or losses at maturity, are recorded as other income(expense) in the Company’s statements of operations.

 

Pursuant to SFAS 133, as amended by SFAS 149, the derivativeinstruments assumed in connection with the SWR acquisition (see Note 4)are deemed to contain a significant financing element, and all cash flowsassociated with the settlement of these positions are reported as a financingactivity in the consolidated statements of cash flows.

 

**10.****          FinancialInstruments**

 

Cashand cash equivalents, receivables, accounts payable and accrued liabilitieswere each estimated to have a fair value approximating the carrying amount dueto the short maturity of those instruments. Indebtedness under the secured bank credit facility was estimated tohave a fair value approximating the carrying amount since the stated interestrate is generally market sensitive. Abandonment obligations are carried at net present value which approximatestheir fair value since the discount rate is based on the Company’scredit-adjusted, risk-free rate.  Thefair value of other noncurrent liabilities approximate their carrying value.

 

14

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Thefair values of derivatives as of June 30, 2005 and December 31, 2004are set forth below.  The associatedcarrying values at these dates are equal to their estimated fair values.

 
| ** **                 | ** ** | **June 30,**  | ** ** | **December 31,** | ** ** |
|----------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                 | ** ** | **2005**           | ** ** | **2004**              | ** ** |
| ** **                 | ** ** | **(In thousands)** | ** ** |
| Liabilities:               |       |               |       |                  |       |
| Commodity  derivatives     |       | $                  | (76,664    | )                     | $          | (41,162 | ) |
| Interest rate  derivatives |       | (1,208             | )          | (1,489                | )          |
| Net liabilities            |       | $                  | (77,872    | )                     | $          | (42,651 | ) |

 

**11.****          IncomeTaxes**

 

Deferredtax assets and liabilities are the result of temporary differences between thefinancial statement carrying values and the tax bases of assets andliabilities.  Significant components ofnet deferred tax liabilities at June 30, 2005 and December 31, 2004are as follows:

 
| ** **                                            | ** ** | **June 30,**  | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                            | ** ** | **2005**           | ** ** | **2004**              | ** ** |
| ** **                                            | ** ** | **(In thousands)** | ** ** |
| Deferred tax  assets:                                 |       |               |       |                  |       |
| Net operating  loss carryforwards                     |       | $                  | 1,414      |                  | $          | 7,915 |   |
| Accrued  stock-based compensation                     |       | 333                |       | 240                   |       |
| Fair value of  derivatives                            |       | 27,257             |       | 14,930                |       |
| Credits related  to alternative minimum tax           |       | 409                |       | 279                   |       |
| Depletion  carryforwards                              |       | 3,488              |       | 3,209                 |       |
| Other                                                 |       | 5,213              |       | 5,058                 |       |
|                                                  |       | 38,114             |       | 31,631                |       |
| Deferred tax  liabilities:                            |       |               |       |                  |       |
| Property and  equipment                               |       | (74,334            | )          | (67,903               | )          |
| Net deferred tax  liabilities                         |       | $                  | (36,220    | )                     | $          | (36,272 | ) |
| Components of  net deferred tax assets (liabilities): |       |               |       |                  |       |
| Current assets                                        |       | $                  | 691        |                  | $          | 625 |   |
| Non-current  liabilities                              |       | (36,911            | )          | (36,897               | )          |
|                                                  |       | $                  | (36,220    | )                     | $          | (36,272 | ) |

 

Forthe six months ended June 30, 2005 and 2004, the Company’s effectiveincome tax rates were different than the statutory federal income tax rates forthe following reasons:

 
| ** **                                             | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                             | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| ** **                                             | ** ** | **(In thousands)**                  | ** ** |
| Income tax  expense (benefit) at statutory rate of 35% |       | $                                   | 365        |   | $ | 4,080 |   |
| Tax depletion in  excess of basis                      |       | (280                                | )          | (105 | ) |
| Income tax  expense (benefit)                          |       | $                                   | 85         |   | $ | 3,975 |   |
| Current                                                |       | $                                   | 130        |   | $ | — |   |
| Deferred                                               |       | (45                                 | )          | 3,975 |   |
| Income tax  expense (benefit)                          |       | $                                   | 85         |   | $ | 3,975 |   |

 

15

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The Company derives anincome tax benefit when employees and directors exercise options granted underthe Company’s stock compensation plans (see Note 8).  Employee stock options that are classified asfixed stock options under APB 25 do not result in a charge against book incomewhen the option price is equal to or greater than the market price at date ofgrant.  Therefore, any tax benefit fromthe exercise of fixed stock options results in a permanent difference, which isrecorded to additional paid-in capital when the tax benefit is realized.

 

Inconnection with the SWR merger, the Company acquired $29.3 million of tax losscarryforwards that are subject to limitations under Internal Revenue Code Section 382from a prior change in control that occurred in April 2002 and from thechange in control of SWR that occurred in connection with the Company’sacquisition of SWR in May 2004.  TheCompany has completed a review of the facts surrounding these changes incontrol and presently believes that it will be able to utilize all of SWR’s taxloss carryforwards.

 

At June 30,2005, the Company’s cumulative tax loss carryforwards were approximately $4 million.  Based upon current commodity prices andproduction volumes, as well as the availability of tax planning strategies(such as elective capitalization of intangible drilling costs), the Companybelieves that it is more likely than not that the Company will be able toutilize these tax loss carryforwards before they expire (beginning in2008).  Accordingly, no valuation allowance exists at June 30, 2005or December 31, 2004.

 

16

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**Item 2 -****  Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

The following discussion is intended to provideinformation relevant to an understanding of our financial condition, changes inour financial condition and our results of operations and cash flows and shouldbe read in conjunction with our consolidated financial statements and notesthereto included elsewhere in this Form 10-Q and in our Form 10-Kfor the year ended December 31, 2004.

 

**Overview**

 

We are an oil and natural gas exploration,development, acquisition and production company.  Our basic business model is to find anddevelop oil and gas reserves through exploration and development activities,and sell the production from those reserves at a profit.  To be successful, we must, over time, be ableto find oil and gas reserves and then sell our discovered production at a pricethat is sufficient to cover our finding costs, operating expenses,administrative costs and interest expense, plus offer us a return on ourcapital investment.

 

Fromtime to time, we may also acquire producing properties if we believe theacquired assets offer us the potential for reserve growth through additionaldevelopmental or exploratory drilling activities.  The acquisition of Southwest Royalties, Inc.(“SWR”) in May 2004 provided us with a number of well locations suitablefor developmental drilling and also enhanced our ability to conduct explorationactivities on or adjacent to some of the acquired properties.

 

We believe that the economic climate in thedomestic oil and gas industry continues to be suitable for our businessmodel.  Oil and gas prices have remainedstrong.  Supply and demand fundamentalscontinue to suggest that energy prices will remain high for the near term, providingus with the economic incentives necessary for us to assume the risks we face inour search for oil and gas reserves.

 

Finding quality domestic oil and gas reservesthrough exploration is a significant challenge and involves a high degree ofrisk.  Although our recent explorationresults have improved, our drilling successes in 2002 and 2003 were limited anddid not find sufficient reserves to replace our production through explorationactivities.  In order to grow our reservebase through our exploration program, we need to continue to improve ourdrilling success.  We will also continueto look for opportunities to complement our exploration program through thepurchase of proved reserves as we did in 2004 with the acquisition of SWR.

 

**KeyFactors to Consider**

 

The following summarizes the key factors consideredby management in the review of our financial condition and operatingperformance for the second quarter of 2005 and the outlook for the remainder of2005.

 

•    Productionfor the second quarter of 2005, on an Mcfe basis, was up 22% from the secondquarter of 2004.  Incremental productionfrom the acquisition of SWR in May 2004 contributed significantly to theincrease in production.  The combinationof increased production and favorable product prices has resulted insignificant increases in oil and gas sales and cash flow from operatingactivities.

 

•    Explorationcosts related to abandonments and impairments were $6.4 million during the secondquarter of 2005, of which $4.5 million was related to the Deer-Hamilton #1well in south Texas.

 

17

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•    We recorded a loss of $9.8 millionrelated to the change in fair value of derivatives during the second quarter of2005. Cash settlements to counterparties accounted for $6.1 million ofthis loss, and changes in mark-to-market valuations accounted for $3.7 million.  Since we do not presently designate ourderivatives as cash flow hedges under applicable accounting standards, werecognize the full effect of changing prices on mark-to-market valuations as acurrent charge or credit to results of operations.

 

•    Wecurrently plan to spend $145.2 million in 2005 on exploration anddevelopment activities, of which approximately 70% relates to exploratoryprospects.  We cannot predict our drilling success on exploratoryprospects, and our future results of operations and financial condition couldbe adversely affected by unsuccessful exploratory drilling results.

 

•    In July 2005,we significantly improved our liquidity by issuing $225 million ofaggregate principal amount of 73⁄4% Senior Notes due 2013.  With net proceeds from the Senior Notes ofapproximately $217 million, we repaid all amounts outstanding on our securedcredit facilities and currently have approximately $132.5 million borrowingcapacity available under our revolving credit facility.

 

**Recent Exploration andDevelopmental Activities**

*** ***

***South Louisiana***

The following table sets forth certain informationabout our exploratory well activities in south Louisiana subsequent to December 31,2004.

 
| ** **         | ** ** | ** **                               | ** ** | **Working**  | ** ** | **Current**                      |
|--------------------|------------|------------------------------------------|------------|--------------|------------|----------------------------------|
| **Spud Date**      | ** ** | **Well Name (Prospect)**                 | ** ** | **Interest** | ** ** | **Status**                       |
| August 2004   |       | McIlhenny #1 (Tabasco)                   |       | 33           | %          | Dry                              |
| November 2004 |       | Orleans Levee District #1 (American Bay) |       | 45           | %          | Waiting on production facilities |
| February 2005 |       | State Lease 18065 #1 (Alabama)           |       | 100          | %          | Waiting on production facilities |
| July 2005     |       | Ransom #1 (Keck)                         |       | 50           | %          | Drilling                         |

 

We are currently constructing production facilitiesfor the Orleans Levee District #1 (American Bay) and the State Lease18065 #1 (Alabama) and expect to begin selling production from these wellsin the fourth quarter of 2005.

 

***Permian Basin***

Subsequent to December 31, 2004, we havedrilled 16 gross (13.4 net) operated wells in various fields in the PermianBasin, all of which were completed as producers.  Most of these wells contributed favorably toour second quarter 2005 production.  Inaddition, we are currently conducting drilling or completing operations on 10gross (7.7 net) wells in this area.

 

***CottonValley Reef Complex***

During the first quarter of 2005, we abandoned theCatherine Destefano #1, a 14,600-foot exploratory well in RobertsonCounty, Texas targeting the Knowles formation, resulting in a pretax charge of$7.2 million.

 

18

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***Other***

We abandoned the Deer-Hamilton #1 well, a17,000-foot exploratory well in Nueces County, Texas targeting theVicksburg formation, in August 2005. We recorded a pretax charge of $4.5 million during the secondquarter of 2005 in connection with this abandonment and will record anadditional charge of approximately $3.2 million during the third quarterof 2005.

 

**Supplemental Information**

The following unaudited information is intended to supplement theconsolidated financial statements included in this Form 10-Q withdata that is not readily available from those statements.

 
| ** **                                       | ** **                 | **Three Months Ended  June 30,** | ** ** |
|--------------------------------------------------|----------------------------|---------------------------------------|------------|
| ** **                                       | ** **                 | **2005**                              | ** ** | **2004** | ** ** |
| **Oil and  Gas Production Data:**                | ** **                 | ** **                            | ** ** | ** ** | ** ** |
| Gas (MMcf)                                       |                       | 4,547                                 |       | 4,105 |   |
| Oil (MBbls)                                      |                       | 615                                   |       | 465 |   |
| Natural gas  liquids (MBbls)                     |                       | 67                                    |       | 35 |   |
| Total (MMcfe)                                    |                       | 8,639                                 |       | 7,105 |   |
| **Average  Realized Prices (1):**                | ** **                 | ** **                            | ** ** | ** ** | ** ** |
| Gas ($/Mcf)                                      |                       | $                                     | 6.62       |   | $ | 5.68 |   |
| Oil ($/Bbl)                                      |                       | $                                     | 50.35      |   | $ | 37.04 |   |
| Natural gas  liquids ($/Bbl):                    |                       | $                                     | 31.73      |   | $ | 22.34 |   |
| **Losses  on Settled Derivative Contracts (1):** | ** **                 | ** **                            | ** ** | ** ** | ** ** |
| ($ in thousands,  except per unit)          |                       |                                  |       |   |   |
| Gas:                                             | Net realized loss          |                                  | $          | (1,271 | ) | $ | (950 | ) |
|                                             | Per unit produced ($/Mcf)  |                                  | $          | (.51 | ) | $ | (.49 | ) |
| Oil:                                             | Net realized loss          |                                  | $          | (4,763 | ) | $ | (1,855 | ) |
|                                             | Per unit produced ($/Bbl)  |                                  | $          | (16.50 | ) | $ | (8.79 | ) |
| **Average  Daily Production:**                   | ** **                 | ** **                            | ** ** | ** ** | ** ** |
| Natural Gas  (Mcf):                              |                       |                                  |       |   |   |
|                                             | Permian Basin              |                                  | 16,063     |   | 7,505 |   |
|                                             | Louisiana                  |                                  | 14,604     |   | 9,898 |   |
|                                             | Austin Chalk (Trend)       |                                  | 2,103      |   | 3,110 |   |
|                                             | Cotton Valley Reef Complex |                                  | 16,618     |   | 23,295 |   |
|                                             | Other                      |                                  | 579        |   | 1,302 |   |
|                                             | Total                      |                                  | 49,967     |   | 45,110 |   |
| Oil (Bbls):                                      |                       |                                  |       |   |   |
|                                             | Permian Basin              |                                  | 3,281      |   | 2,109 |   |
|                                             | Louisiana                  |                                  | 1,494      |   | 693 |   |
|                                             | Austin Chalk  (Trend)      |                                  | 1,920      |   | 2,242 |   |
|                                             | Other                      |                                  | 63         |   | 66 |   |
|                                             | Total                      |                                  | 6,758      |   | 5,110 |   |
| Natural Gas  Liquids (Bbls):                     |                       |                                  |       |   |   |
|                                             | Permian Basin              |                                  | 220        |   | 83 |   |
|                                             | Austin Chalk  (Trend)      |                                  | 392        |   | 136 |   |
|                                             | Other                      |                                  | 124        |   | 166 |   |
|                                             | Total                      |                                  | 736        |   | 385 |   |

 

(Continued)

 

19

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| ** **                                | ** ** | **Three Months Ended  June 30,** | ** ** |
|-------------------------------------------|------------|---------------------------------------|------------|
| ** **                                | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| **Exploration  Costs (in thousands):**    |       |                                  |       |   |   |
| Abandonment and  impairment costs:        |       |                                  |       |   |   |
| Louisiana                                 |       | $                                     | 205        |   | $ | 12,206 |   |
| Cotton Valley Reef  Complex               |       | 154                                   |       | — |   |
| Mississippi                               |       | 876                                   |       | — |   |
| Permian Basin                             |       | 684                                   |       | — |   |
| South Texas                               |       | 4,511                                 |       | — |   |
| Nevada, Arizona,  California and Utah     |       | —                                |       | 1,104 |   |
| Other                                     |       | —                                |       | 157 |   |
| Total                                     |       | 6,430                                 |       | 13,467 |   |
| Seismic and  other                        |       | 1,665                                 |       | 1,812 |   |
| Total  exploration costs                  |       | $                                     | 8,095      |   | $ | 15,279 |   |
| **Oil and  Gas Costs ($/Mcfe Produced):** |       |                                  |       |   |   |
| Production costs                          |       | $                                     | 1.60       |   | $ | 1.15 |   |
| Oil and gas  depletion                    |       | $                                     | 1.34       |   | $ | 1.19 |   |
| **Net  Wells Drilled (2):**               |       |                                  |       |   |   |
| Exploratory  Wells                        |       | 7.5                                   |       | 2.5 |   |
| Developmental  Wells                      |       | 15.9                                  |       | 1.7 |   |

 
| ** **                                       | ** **                 | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------|----------------------------|-------------------------------------|------------|
| ** **                                       | ** **                 | **2005**                            | ** ** | **2004** | ** ** |
| **Oil and  Gas Production Data:**                | ** **                 | ** **                          | ** ** | ** ** | ** ** |
| Gas (MMcf)                                       |                       | 9,308                               |       | 8,282 |   |
| Oil (MBbls)                                      |                       | 1,234                               |       | 840 |   |
| Natural gas  liquids (MBbls)                     |                       | 133                                 |       | 104 |   |
| Total (MMcfe)                                    |                       | 17,510                              |       | 13,946 |   |
| **Average  Realized Prices(1):**                 | ** **                 | ** **                          | ** ** | ** ** | ** ** |
| Gas ($/Mcf)                                      |                       | $                                   | 6.41       |   | $ | 5.42 |   |
| Oil ($/Bbl)                                      |                       | $                                   | 49.08      |   | $ | 35.67 |   |
| Natural gas  liquids ($/Bbl):                    |                       | $                                   | 29.63      |   | $ | 23.82 |   |
| **Losses  on Settled Derivative Contracts (1):** | ** **                 | ** **                          | ** ** | ** ** | ** ** |
| ($ in thousands,  except per unit)          |                       |                                |       |   |   |
| Gas:                                             | Net realized  loss         |                                | $          | (562 | ) | $ | (950 | ) |
|                                             | Per unit  produced ($/Mcf) |                                | $          | (.06 | ) | $ | (.49 | ) |
| Oil:                                             | Net realized  loss         |                                | $          | (8,983 | ) | $ | (2,004 | ) |
|                                             | Per unit  produced ($/Bbl) |                                | $          | (15.32 | ) | $ | (7.68 | ) |

 

(Continued)

 

20

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| ** **                                | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------------------------|------------|-------------------------------------|------------|
| ** **                                | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| **Average  Daily Production:**            | ** ** | ** **                          | ** ** | ** ** | ** ** |
| Natural Gas  (Mcf):                       |       |                                |       |   |   |
| Permian Basin                             |       | 16,110                              |       | 4,670 |   |
| Louisiana                                 |       | 14,935                              |       | 10,319 |   |
| Austin Chalk  (Trend)                     |       | 2,329                               |       | 3,386 |   |
| Cotton Valley  Reef Complex               |       | 17,312                              |       | 25,707 |   |
| Other                                     |       | 739                                 |       | 1,423 |   |
| Total                                     |       | 51,425                              |       | 45,505 |   |
| Oil (Bbls):                               |       |                                |       |   |   |
| Permian Basin                             |       | 3,305                               |       | 1,524 |   |
| Louisiana                                 |       | 1,485                               |       | 716 |   |
| Austin Chalk  (Trend)                     |       | 1,976                               |       | 2,318 |   |
| Other                                     |       | 52                                  |       | 57 |   |
| Total                                     |       | 6,818                               |       | 4,615 |   |
| Natural Gas  Liquids (Bbls):              |       |                                |       |   |   |
| Permian Basin                             |       | 227                                 |       | 135 |   |
| Austin Chalk  (Trend)                     |       | 365                                 |       | 252 |   |
| Other                                     |       | 143                                 |       | 184 |   |
| Total                                     |       | 735                                 |       | 571 |   |
| **Exploration  Costs (in thousands):**    |       |                                |       |   |   |
| Abandonment and  impairment costs:        |       |                                |       |   |   |
| Louisiana                                 |       | $                                   | 1,477      |   | $ | 15,895 |   |
| Cotton Valley  Reef Complex               |       | 7,400                               |       | 44 |   |
| Mississippi                               |       | 3,337                               |       | 85 |   |
| Permian Basin                             |       | 975                                 |       | 375 |   |
| South Texas                               |       | 4,511                               |       | — |   |
| Nevada, Arizona,  California and Utah     |       | —                              |       | 1,683 |   |
| Other                                     |       | —                              |       | 17 |   |
| Total                                     |       | 17,700                              |       | 18,099 |   |
| Seismic and  other                        |       | 2,453                               |       | 3,737 |   |
| Total  exploration costs                  |       | $                                   | 20,153     |   | $ | 21,836 |   |
| **Oil and  Gas Costs ($/Mcfe Produced):** |       |                                |       |   |   |
| Production costs                          |       | $                                   | 1.51       |   | $ | 1.08 |   |
| Oil and gas  depletion                    |       | $                                   | 1.32       |   | $ | 1.17 |   |
| **Net  Wells Drilled (2):**               |       |                                |       |   |   |
| Exploratory  Wells                        |       | 10.8                                |       | 4.6 |   |
| Developmental  Wells                      |       | 24.8                                |       | 7.2 |   |

 

----

(1)         Hedging gains (losses) are only included in the determination of ouraverage realized prices if the underlying derivative contracts are designatedas cash flow hedges under applicable accounting standards.  We did not designate any of our 2004 or 2005derivative contracts as cash flow hedges. This means that our derivatives for 2004 and 2005 have been marked-to-marketthrough our statement of operations as other income/expense instead of throughaccumulated other comprehensive income on our balance sheet.  This also means that all realizedgains/losses on these derivatives are reported in other income/loss instead ofas a component of oil and gas sales.

 

(2)         Excludes wells being drilled or completed at the end of each period.

 

21

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**Operating Results — Three-Month Periods**

 

The following discussion compares our results forthe three months ended June 30, 2005 to the comparative period in2004.  Unless otherwise indicated,references to 2005 and 2004 within this section refer to the respectivequarterly period.

 

***Oil and gas operating results***

 

Oil and gas sales in 2005 increased 54% from 2004due primarily to higher product prices and an increase in oil and gasproduction on an Mcfe basis.  Oil and gassales increased $22.2 million, of which price variances accounted for a $13.1 millionincrease and production variances accounted for a $9.1 million increase.

 

Production in 2005 (on an Mcfe basis) was 22%higher than 2004.  We increased our oilproduction 32% in 2005 from 2004 primarily through the acquisition of SWR in May 2004and as a result of production from new wells in Louisiana.  Our gas production increased 11% in 2005 from2004 due primarily to additional gas production from the SWR acquisition andproduction from new wells in Louisiana, offset in part by normal productiondeclines in the Cotton Valley Reef Complex area.  We expect our oil and gas production forfiscal 2005 to exceed fiscal 2004 levels due to our ongoing developmentaldrilling program in the Permian Basin, without taking into account any newproduction from our exploration program or from acquisitions of provedreserves.

 

In 2005, our realized oil price was 36% higher than2004, while our realized gas price was 17% higher.  Historically, the markets for oil and gashave been volatile, and they are likely to continue to be volatile.

 

Oil and gas production costs on an Mcfe basisincreased from $1.15 per Mcfe in 2004 to $1.60 per Mcfe in 2005.  The increase in operating costs in 2005 wasprimarily due to the added expense related to higher cost oil propertiesacquired in connection with the SWR merger, as well as increased production taxcosts related to higher product prices. In addition, an increase in workover activities designed to improveproduction from existing wells contributed to higher production costs.  It is likely that these factors will continueto contribute to higher production costs in future periods.

 

Depreciation, depletion, and amortization (“DD&A”)expense attributable to our oil and gas properties increased $3 million,of which production variances accounted for $2 million and rate variancesaccounted for $1 million.  On anMcfe basis, DD&A expense increased 13% from $1.19 per Mcfe in 2004 to $1.34per Mcfe in 2005.  Depletion rates foreach depletable group are a function of net capitalized costs and estimatedreserve quantities.

 

General and administrative (“G&A”) expenses,excluding non-cash stock-based employee compensation, decreased 3% in 2005 ascompared to 2004 due primarily to administrative efficiencies afforded by thecombination of our operating activities with those of SWR.  A greater portion of our corporate G&Aexpenses are being borne by participants in wells we operate through overheadcharges billable under applicable operating agreements.  G&A expenses for 2005 include a non-cashcharge of $162,000 for stock-based employee compensation required by FinancialAccounting Standards Board Interpretation No. 44.  A $782,000 non-cashcredit (reduction of expense) was required for the 2004 period.  Since theamount of this non-cash provision or credit is based on the quoted market valueof our common stock, the future results of our operations may be subject tosignificant volatility based on changes in the market price of our commonstock.

 

22

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***Exploration costs***

 

Since we follow the successful efforts method ofaccounting, our results of operations are adversely affected during anyaccounting period in which significant seismic costs, exploratory dry holecosts, and unproved acreage impairments are expensed.  In 2005, we chargedto expense $8.1 million of exploration costs, as compared to $15.3 millionin 2004.  Most of these costs were incurred in Louisiana, Mississippi andsouth Texas.

 

We plan to spend approximately $145.2 millionon exploration and development activities in fiscal 2005, of which 70% isexpected to be allocated to exploration activities.  Since exploratorydrilling involves a high degree of risk, it is likely that a significantportion of the remaining costs in fiscal 2005 will be charged to explorationcosts. However, we cannot predict our success rates and, accordingly, cannotpredict our exploration costs related to abandonment and impairment costs.

 

***Interestexpense***

 

Interest expense increased from $1.4 millionin 2004 to $2.6 million in 2005 due primarily to higher average levels ofindebtedness under our credit facilities and higher effective interestrates.  The average daily principalbalance outstanding under the credit facilities for 2005 was $191.2 millioncompared to $123.6 million in 2004.  The increased borrowings wereprimarily a result of the acquisition of SWR in May 2004.  Theeffective annual interest rate on bank debt, including bank fees and interestrate derivatives, during 2005 was 6.3% compared to 4.8% in 2004.  We expect interest expense to increase infuture periods due to the issuance of $225 million of aggregate principalamount of 73⁄4% Senior Notes due 2013 in July 2005.

 

***Change in fair value ofderivatives***

 

We recorded a loss of $9.8 million in 2005 forthe change in fair value of derivatives compared to a loss of $309,000 for2004.  We have not designated anyderivative contracts in 2005 or 2004 as cash flow hedges; therefore all cashsettlements and changes resulting from mark-to-market valuations are recordedas changes in fair value of derivatives. For 2005, cash settlements were $6.1 million and non-cash mark-to-marketadjustments were $3.7 million, as compared to cash settlements of $2.8 millionand non-cash mark-to-market adjustments of a $2.5 million gain for the2004 period.  Future gains or losses onchanges in derivatives will be impacted by the volatility of commodity andinterest rates, as well as the terms of any new derivative contracts.

 

**Operating Results — Six-Month Periods**

 

The following discussion compares our results forthe six months ended June 30, 2005 to the comparative period in 2004.  Unless otherwise indicated, references to2005 and 2004 within this section refer to the respective six-monthperiod.

 

***Oil and gas operating results***

 

Oil and gas sales in 2005 increased 61% from 2004due primarily to higher product prices and an increase in oil and gasproduction on an Mcfe basis.  Oil and gassales increased $47.3 million, of which price variances accounted for a $26.7 millionincrease and production variances accounted for a $20.6 million increase.

 

23

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Production in 2005 (on an Mcfe basis) was 26%higher than 2004.  We increased our oilproduction in 2005 primarily through the acquisition of SWR in May 2004 andas a result of production from new wells in Louisiana.  Our gas production increased 12% in 2005 from2004 due primarily to additional gas production from the SWR acquisition andproduction from new wells in Louisiana, offset in part by normal productiondeclines in the Cotton Valley Reef Complex area.  We expect our oil and gas production forfiscal 2005 to exceed fiscal 2004 levels due to our ongoing developmentaldrilling program in the Permian Basin, without taking into account any newproduction from our exploration program or from acquisitions of provedreserves.

 

In 2005, our realized oil price was 38% higher than2004, while our realized gas price was 18% higher.  Historically, the markets for oil and gashave been volatile, and they are likely to continue to be volatile.

 

Oil and gas production costs on an Mcfe basisincreased from $1.08 per Mcfe in 2004 to $1.51 per Mcfe in 2005.  The increase in operating costs in 2005 wasprimarily due to the added expense related to higher cost oil properties acquiredin connection with the SWR merger, as well as increased production tax costsrelated to higher product prices.  Inaddition, an increase in workover activities designed to improve productionfrom existing wells contributed to higher production costs.  It is likely that these factors will continueto contribute to higher production costs in future periods.

 

DD&A expense attributable to our oil and gasproperties increased $6.8 million, of which production variances accountedfor $4.5 million and rate variances accounted for $2.3 million.  On an Mcfe basis, DD&A expense increased13% from $1.17 per Mcfe in 2004 to $1.32 per Mcfe in 2005.  Depletion rates for each depletable group area function of net capitalized costs and estimated reserve quantities.

 

G&A expenses, excluding non-cash stock-basedemployee compensation, decreased 7% in 2005 as compared to 2004 due primarilyto administrative efficiencies afforded by the combination of our operatingactivities with those of SWR.  A greaterportion of our corporate G&A expenses are being borne by participants inwells we operate through overhead charges billable under applicable operatingagreements.  G&A expenses for 2005include a non-cash charge of $280,000 for stock-based employee compensationrequired by Financial Accounting Standards Board Interpretation No. 44. A $205,000 credit (reduction of expense) was required for the 2004period.  Since the amount of this non-cash provision or credit is based onthe quoted market value of our common stock, the future results of ouroperations may be subject to significant volatility based on changes in themarket price of our common stock.

 

***Gain onproperty sales***

 

Gain on sales of property and equipment for 2005was $2.1 million, as compared to $66,000 in 2004.  The 2005 gain included the sale of variousnon-core wells in east Texas and lease acreage sales.

 

***Exploration costs***

 

Since we follow the successful efforts method ofaccounting, our results of operations are adversely affected during anyaccounting period in which significant seismic costs, exploratory dry holecosts, and unproved acreage impairments are expensed.  In 2005, we chargedto expense $20.2 million of exploration costs, as compared to $21.8 millionin 2004.  Most of these costs were incurred in the Cotton Valley ReefComplex, Mississippi, south Louisiana and south Texas.

 

24

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We plan to spend approximately $145.2 millionon exploration and development activities in fiscal 2005, of which 70% is expectedto be allocated to exploration activities.  Since exploratory drillinginvolves a high degree of risk, it is likely that a significant portion of theremaining costs in fiscal 2005 will be charged to exploration costs. However,we cannot predict our success rates and, accordingly, cannot predict ourexploration costs related to abandonment and impairment costs.

 

***Interestexpense***

 

Interest expense increased from $1.9 millionin 2004 to $4.9 million in 2005 due primarily to higher average levels ofindebtedness under our credit facilities and higher effective interestrates.  The average daily principalbalance outstanding under the credit facilities for 2005 was $187.2 millioncompared to $86.9 million in 2004.  The increased borrowings wereprimarily a result of the acquisition of SWR in May 2004.  Theeffective annual interest rate on bank debt, including bank fees and interestrate derivatives, during 2005 was 6.1% compared to 4.5% in 2004.  We expect interest expense to increase infuture periods due to the issuance of $225 million of aggregate principalamount of 73⁄4% Senior Notes due 2013 in July 2005.

 

***Change in fair value ofderivatives***

 

We recorded a loss of $44.9 million in 2005for the change in fair value of derivatives compared to a loss of $3.4 millionfor 2004.  We have not designated anyderivative contracts in 2005 or 2004 as cash flow hedges; therefore all cashsettlements and changes resulting from mark-to-market valuations are recordedas changes in fair value of derivatives. For 2005, cash settlements were $9.7 million and non-cash mark-to-marketadjustments were $35.2 million, as compared to cash settlements of $3 millionand non-cash mark-to-market adjustments of $447,000 for the 2004 period.  Future gains or losses on changes in derivativeswill be impacted by the volatility of commodity and interest rates, as well asthe terms of any new derivative contracts.

 

**Liquidity and Capital Resources**

 

***Overview***

 

Our primary financial resource is our base of oiland gas reserves.  We pledge our producingoil and gas properties to a group of banks to secure our revolving creditfacility and, until July 2005, our senior term credit facility.  The banks establish a borrowing base bymaking an estimate of the collateral value of our oil and gas properties.  We borrow funds on the revolving creditfacility as needed to supplement our operating cash flow as a financing sourcefor our capital expenditure program.  Ourability to fund our capital expenditure program is dependent upon the level ofproduct prices and the success of our exploration program in replacing ourexisting oil and gas reserves.  Ifproduct prices decrease, our operating cash flow may decrease and the banks mayrequire additional collateral or reduce our borrowing base, thus reducing fundsavailable to fund our capital expenditure program.  The effects of product prices on cash flowcan be mitigated through the use of commodity derivatives.  If we are unable to replace our oil and gasreserves through our exploration program, we may also suffer a reduction in ouroperating cash flow and access to funds under the revolving creditfacility.  Under extreme circumstances,product price reductions or exploration drilling failures could allow the banksto seek to foreclose on our oil and gas properties, thereby threatening ourfinancial viability.

 

In July 2005, we reduced our dependence on theborrowing base established for the revolving credit facility by issuing$225 million of aggregate principal amount of 73⁄4% Senior Notes due 2013and using the

 

25

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net proceeds to repay all amountsoutstanding on the revolving credit facility and the senior term creditfacility.

 

In this section, we will describe our current plansfor capital spending, identify the capital resources available to finance ourcapital spending, and discuss the principal factors that can affect ourliquidity and capital resources.

 

***Capital expenditures***

 

Our total planned expenditures for exploration anddevelopment activities during fiscal 2005 are $145.2 million, assummarized by area in the following table.

 
| ** **            | ** ** | **Actual**             | ** ** | **Total**                  | ** ** | ** **     | ** ** |
|-----------------------|------------|------------------------|------------|----------------------------|------------|----------------|------------|
| ** **            | ** ** | **Expenditures**       | ** ** | **Planned**                | ** ** | ** **     | ** ** |
| ** **            | ** ** | **Six Months**         | ** ** | **Expenditures**           | ** ** | ** **     | ** ** |
| ** **            | ** ** | **Ended**              | ** ** | **Year Ended**             | ** ** | **Percentage** | ** ** |
| ** **            | ** ** | **June 30, 2005** | ** ** | **December 31, 2005** | ** ** | **of Total**   | ** ** |
| ** **            | ** ** | **(In thousands)**     | ** ** |
| Permian Basin         |       | $                      | 31,900     |                       | $          | 59,000         |       | 41 | % |
| Louisiana             |       | 17,400                 |       | 51,900                     |       | 36             | %          |
| South and east  Texas |       | 10,000                 |       | 17,500                     |       | 12             | %          |
| Utah/Montana          |       | 5,500                  |       | 12,000                     |       | 8              | %          |
| Mississippi           |       | 3,300                  |       | 3,800                      |       | 2              | %          |
| Other                 |       | —                 |       | 1,000                      |       | 1              | %          |
|                  |       | $                      | 68,100     |                       | $          | 145,200        |       | 100 | % |

 

Our actual expenditures during fiscal 2005 may besubstantially higher or lower than these estimates since our plans forexploration and development activities may change during the year.  Other factors, such as prevailing productprices and the availability of capital resources, could also increase ordecrease the ultimate level of expenditures during fiscal 2005.

 

Approximately 70% of the planned expendituresrelate to exploratory prospects. Exploratory prospects involve a higher degree of risk than developmentalprospects.  To offset the higher risk, wegenerally strive to achieve a higher reserve potential and rate of return oninvestments in exploratory prospects.  Wedo not attempt to forecast our success rate on exploratory drilling.  Accordingly, these current estimates do notinclude costs we may incur to complete any future successful exploratory wellsand construct the required production facilities for these wells.  Also, we are actively searching for other opportunitiesto increase our oil and gas reserves, including the evaluation of new prospectsfor exploratory and developmental drilling activities and potentialacquisitions of proved oil and gas properties.

 

We project that most of the cash needed to finance ourplanned expenditures for exploration and development activities in fiscal 2005will be provided by operating activities. To the extent that actual costs exceed our cash provided by operatingactivities, we plan to utilize the remaining proceeds from our Senior Notesoffering and the existing availability under the revolving credit facility tofinance such excess.

 

26

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***Cash flow provided by operating activities***

 

Substantially all of our cash flow from operatingactivities is derived from the production of our oil and gas reserves.  We use this cash flow to fund our on-goingexploration and development activities in search of new oil and gasreserves.  Variations in cash flow fromoperating activities may impact our level of exploration and developmentexpenditures.

 

Cash flow provided by operating activities for the sixmonths ended June 30, 2005 was 40% higher than the same period in 2004 dueto the combined effects of several drivers. The positive benefits of a 61% increase in oil and gas sales, drivenprimarily by higher oil and gas prices and an increase in production, wereoffset in part by increases in production costs, costs of settling commodityhedges and interest expense.  Our primarysource of cash from operating activities is our oil and gas sales, net ofproduction costs.  Our cash flow providedby operating activities is subject to material variation from changes in oiland gas production levels and product prices. Higher oil and gas prices also resulted in an increase in cash requiredto settle derivative contracts, excluding those contracts that contain afinancing element as in the case of the contracts assumed in the SWRacquisition.  Interest expense increasedin 2005 due primarily to higher levels of indebtedness resulting from the SWRacquisition.

 

***Credit facilities***

 

A group of banks have provided us with a revolvingcredit facility on which we have historically relied for both our short-termliquidity (working capital) and our long-term financing needs.  The funds available to us at any time underthis revolving credit facility are limited to the amount of the borrowing baseestablished by the banks.  As long as wehave sufficient availability under this credit facility to meet our obligationsas they come due, we will have sufficient liquidity and will be able to fundany short-term working capital deficit.

 

At the beginning of 2005, we had an outstandingbalance under the revolving credit facility of $147.5 million, and theborrowing base was $195 million, providing us with available funds of $46.7million after accounting for outstanding letters of credit.  During the six months ended June 30,2005, we generated cash flow from operating activities of $69.3 millionand received proceeds from sales of property and equipment of $2.2 million.  We also spent $79.4 million on capitalexpenditures and other investments and paid $9.8 million to settlederivatives with financing elements.  Theexcess of expenditures over receipts of $17.7 million was financed byborrowings on the revolving credit facility of $12.1 million and cash ondeposit of $5.6 million.  As aresult, the available funds under our revolving credit facility at June 30,2005 was $34.6 million.

 

Using the revolving credit facility for both our short-term liquidity and long-termfinancing needs can cause unusual fluctuations in our reported working capital,depending on the timing of cash receipts and expenditures.  On a daily basis, we use most of ouravailable cash to pay down our outstanding balance on the revolving creditfacility, which is classified as a non-current liability since we currentlyhave no required principal reductions. As we use cash to pay a non-current liability, our reported workingcapital decreases.  Conversely, as wedraw on the revolving credit facility for funds to pay current liabilities(such as payables for drilling and operating costs), our reported workingcapital increases.  Also, volatility inoil and gas prices can cause significant fluctuations in reported workingcapital as we record changes in the fair value of derivatives from period toperiod.  For these reasons, the workingcapital covenant related to the revolving credit facility requires us to (i) includethe amount of funds available under this facility as a current asset, (ii) excludecurrent assets and liabilities related to the fair value of derivatives, and (iii) excludecurrent

 

27

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maturities of vendor finance obligations, ifany when computing the working capital ratio at any balance sheet date.

 

Working capital computed for loan compliancepurposes differs from our working capital in accordance with generally acceptedaccounting principles (GAAP).  Sincecompliance with financial covenants is a material requirement under the creditfacilities, we consider the loan compliance working capital to be useful as ameasure of our liquidity because it includes the funds available to us underthe revolving credit facility and is not affected by the volatility in workingcapital caused by changes in fair value of derivatives.  Our reported working capital deficit decreasedfrom $27.6 million at December 31, 2004 to $20.9 million at June 30,2005 due primarily to a combination of factors, including decreases in accountspayable, increases in inventory and increases in current liabilities related tothe fair value of derivatives.  Aftergiving effect to the adjustments, our working capital computed for loancompliance purposes was a positive $41.3 million at June 30, 2005, ascompared to a positive $32.9 million at December 31, 2004.  The following table reconciles our GAAPworking capital to the working capital computed for loan compliance purposes atJune 30, 2005 and December 31, 2004.

 
| ** **                                                                             | ** ** | **June 30,**  | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                             | ** ** | **2005**           | ** ** | **2004**              | ** ** |
| ** **                                                                             | ** ** | **(In thousands)** | ** ** |
| Working capital  (deficit) per GAAP                                                    |       | $                  | (20,888    | )                     | $          | (27,566 | ) |
| Add funds  available under the revolving credit facility                               |       | 34,596             |       | 46,725                |       |
| Exclude fair  value of derivatives classified as current assets or current liabilities |       | 27,567             |       | 13,693                |       |
| Working capital  per loan covenant                                                     |       | $                  | 41,275     |                  | $          | 32,852 |   |

 

Since we use thisrevolving credit facility for both short-term liquidity and long-term financingneeds, it is important that we comply in all material respects with the loanagreement, including financial covenants that are computed quarterly.  The working capital covenant requires us tomaintain positive working capital using the computations described above.  Another financial covenant under the creditfacility requires us to maintain a ratio of indebtedness to cash flow of nomore than 3 to 1.  While we were incompliance with all financial and non-financial covenants at June 30,2005, our increased leverage and reduced liquidity may result in our failing tocomply with one or more of these covenants in the future.  If we fail tomeet any of these loan covenants, we would ask the banks to allow us sufficienttime to obtain additional capital resources through alternative means.  If a suitable arrangement could not bereached with the banks, the banks could accelerate the indebtedness and seek toforeclose on the pledged assets. However, the issuance of the 73⁄4%**SeniorNotes due 2013 described below significantly increases our liquidity andreduces our dependence on the revolving credit facility.

 

The banks redetermine theborrowing base under the revolving credit facility at least twice a year, in May andNovember.  If at any time, the borrowingbase is less than the amount of outstanding indebtedness, we will be requiredto (i) pledge additional collateral, (ii) prepay the excess in notmore than five equal monthly installments, or (iii) elect to convert theentire amount of outstanding indebtedness to a term obligation based onamortization formulas set forth in the loan agreement.  In connection with the issuance of the 73⁄4%Senior Notes due 2013, the borrowing base was reduced to $132.5 million inJuly 2005, and all outstanding balances on our revolving credit facilitywere repaid.

 

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***73⁄4% Senior Notes due 2013***

 

In July 2005, we issued, in a private placement, $225 million ofaggregate principal amount of 73⁄4% Senior Notes due 2013 (“Senior Notes”).  The Senior Notes were issued at face valueand will bear interest at 73⁄4% per year, payable semi-annually on February 1and August 1 of each year, beginning February 1, 2006.  After the payment of typical transactionexpenses, net proceeds of approximately $217 million were used to repayamounts outstanding on our secured credit facilities and for general corporatepurposes, including the funding of planned exploration and developmentactivities.

 

At any time prior to August 1, 2008, we may redeem up to 35% of theaggregate principal amount of the Senior Notes with the proceeds of certainequity offerings at a redemption price of 107.75% of the principal amount, plusaccrued and unpaid interest.  Inaddition, prior to August 1, 2009, we may redeem some or all of the SeniorNotes at a redemption price equal to 100% of the principal amount of the SeniorNotes to be redeemed, plus a make-whole premium, plus any accrued and unpaidinterest.  On and after August 1,2009, we may redeem some or all of the Senior Notes at redemption prices(expressed as percentages of principal amount) equal to 103.875% for thetwelve-month period beginning on August 1, 2009, 101.938% for thetwelve-month period beginning on August 1, 2010, and 100.00% beginning on August 1,2011, for any period thereafter, in each case plus accrued and unpaid interest.

 

The Indenture governing the Senior Notes restricts our ability and theability of our restricted subsidiaries to: (i) borrowing money; (ii) issue redeemable and preferredstock; (iii) pay distributions or dividends; (iv) make investments; (v) createliens without securing the Notes; (vi) enter into agreements that restrictdividends from subsidiaries; (vii) sell certain assets or merge with orinto other companies; (viii) enter into transactions with affiliates; (ix) guaranteeindebtedness; and (x) enter into new lines of business.  These covenants are subject to a number ofimportant exceptions and qualifications.

 

Since the Senior Noteshave an eight-year maturity and bear interest at a fixed rate of 73⁄4%, we expect our effective annual interestrate to increase in future periods. However, we believe that a fixed rate of interest for the term of theSenior Notes will be beneficial over the long-term.

 

***Alternative capital resources***

 

Although our base of oil and gas reserves, ascollateral for both of our credit facilities, has historically been our primarycapital resource, we have in the past, and we believe we could in the future,use alternative capital resources, such as asset sales, vendor financingarrangements, and/or public or private issuances of common stock.  We could also issue senior or subordinateddebt or preferred stock in a public or a private placement if we choose toraise capital through either of these markets. While we believe we would be able to obtain funds through one or more ofthese alternatives, if needed, there can be no assurance that these capitalresources would be available on terms acceptable to us.

 

## **Item3** -  Quantitative and Qualitative Disclosure About MarketRisks

## ** **

Our business is impacted by fluctuations incommodity prices and interest rates.  Thefollowing discussion is intended to identify the nature of these market risks,describe our strategy for managing such risks, and to quantify the potentialaffect of market volatility on our financial condition and results ofoperations.

 

29

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**Oil andGas Prices**

 

Our financial condition, results of operations, andcapital resources are highly dependent upon the prevailing market prices of,and demand for, oil and natural gas. These commodity prices are subject to wide fluctuations and marketuncertainties due to a variety of factors that are beyond our control.  These factors include the level of globaldemand for petroleum products, foreign supply of oil and gas, the establishmentof and compliance with production quotas by oil-exporting countries, weatherconditions, the price and availability of alternative fuels, and overalleconomic conditions, both foreign and domestic. We cannot predict future oil and gas prices with any degree ofcertainty.  Sustained weakness in oil andgas prices may adversely affect our financial condition and results ofoperations, and may also reduce the amount of net oil and gas reserves that wecan produce economically.  Any reductionin reserves, including reductions due to price fluctuations, can reduce theborrowing base under our revolving credit facility and adversely affect ourliquidity and our ability to obtain capital for our exploration and developmentactivities.  Similarly, any improvementsin oil and gas prices can have a favorable impact on our financial condition,results of operations and capital resources. Based on December 31, 2004 reserve estimates, we project that a$1.00 drop in the price per Bbl of oil and a $.50 drop in the price per Mcf ofgas would reduce our gross revenues for the year ending December 31, 2005by $12.8 million.

 

From time to time, we utilize commodityderivatives, consisting primarily of swaps, floors and collars to attempt tooptimize the price received for our oil and natural gas production.  When using swaps to hedge our oil and naturalgas production, we receive a fixed price for the respective commodity and pay afloating market price as defined in each contract (generally NYMEX futuresprices), resulting in a net amount due to or from the counterparty.  When purchasing floors, we receive a fixedprice (put strike price) if the market price falls below the put strike pricefor the respective commodity.  If themarket price is greater than the put strike price, no payments are due fromeither party.  Costless collars are acombination of puts and calls, and contain a fixed floor price (put strikeprice) and ceiling price (call strike price). If the market price for the respective commodity exceeds the call strikeprice or falls below the put strike price, then we receive the fixed price andpay the market price.  If the marketprice is between the call and the put strike prices, no payments are due fromeither party.  The commodity derivativeswe use differ from futures contracts in that there is not a contractualobligation that requires or permits the future physical delivery of the hedgedproducts.  We do not enter into commodityderivatives for trading purposes.  Inaddition to commodity derivatives, we may, from time to time, sell a portion ofour gas production under short-term contracts at fixed prices.

 

The decision to initiate or terminate commodityhedges is made by management based on its expectation of future market pricemovements.  We have no set goals for thepercentage of our production we hedge and we do not use any formulas ortriggers in deciding when to initiate or terminate a hedge.  If we enter into swaps or collars and thefloating market price at the settlement date is higher than the fixed price orthe fixed ceiling price, we will forego revenue we would have otherwisereceived.  If we terminate a swap, collaror floor because we anticipate future increases in market prices, we may beexposed to downside risk that would not have existed otherwise.

 

The following summarizes information concerning ournet positions in open commodity derivatives applicable to periods subsequent toJune 30, 2005.  The settlementprices of commodity derivatives are based on NYMEX futures prices.

 

30

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**Floors:**

** **
| ** **          | ** ** | **Gas**   | ** ** | **Oil**   | ** ** |
|---------------------|------------|-----------|------------|-----------|------------|
| ** **          | ** ** | **MMBtu** | ** ** | **Floor** | ** ** | **Bbls** | ** ** | **Floor** | ** ** |
| Production  Period: |       |      |       |      |       |   |   |   |   |
| 3rd Quarter 2005    |       | 1,840,000 |       | $         | 4.50       |   | 119,600 |   | $ | 28.00 |   |
| 4th Quarter 2005    |       | 1,840,000 |       | $         | 4.50       |   | 119,600 |   | $ | 28.00 |   |
|                |       | 3,680,000 |       |      |       | 239,200 |   |   |   |

 

**Collars:**

** **
| ** **             | ** ** | **Gas**       | ** ** | **Oil**    | ** ** |
|------------------------|------------|---------------|------------|------------|------------|
| ** **             | ** ** | **MMBtu (a)** | ** ** | **Floor**  | ** ** | **Ceiling** | ** ** | **Bbls** | ** ** | **Floor** | ** ** | **Ceiling** | ** ** |
| **Production Period:** | ** ** | ** **    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| 3rd Quarter 2005       |       | 607,000       |       | $          | 4.00       |   | $ | 5.23 |   | 165,000 |   | $ | 23.00 |   | $ | 25.41 |   |
| 4th Quarter 2005       |       | 588,000       |       | $          | 4.00       |   | $ | 5.23 |   | 162,000 |   | $ | 23.00 |   | $ | 25.41 |   |
| 2006                   |       | 2,024,000     |       | $          | 4.00       |   | $ | 5.21 |   | 613,000 |   | $ | 23.00 |   | $ | 25.32 |   |
| 2007                   |       | 1,831,000     |       | $          | 4.00       |   | $ | 5.18 |   | 562,000 |   | $ | 23.00 |   | $ | 25.20 |   |
| 2008                   |       | 1,279,000     |       | $          | 4.00       |   | $ | 5.15 |   | 392,000 |   | $ | 23.00 |   | $ | 25.07 |   |
|                   |       | 6,329,000     |       |       |       |   |   | 1,894,000 |   |   |   |   |   |

 

----

(a)         OneMMBtu equals one Mcf at a Btu factor of 1,000.

 

We use a sensitivity analysis technique to evaluatethe hypothetical effect that changes in the market value of oil and gas mayhave on the fair value of our commodity derivatives.  A $1 per barrel change in the price ofoil and a $.50 per MMBtu change in the price of gas would change the fair valueof our commodity derivatives by approximately $5 million.

 

**Interest Rate**

 

All of our outstanding bank indebtedness at June 30,2005 is subject to market rates of interest as determined from time to time bythe banks pursuant to the credit facilities. We may designate borrowings under the credit facilities as either “BaseRate Loans” or “Eurodollar Loans.”  BaseRate Loans bear interest at a fluctuating rate that is linked to the discountrates established by the Federal Reserve Board. Eurodollar Loans bear interest at a fluctuating rate that is linked toLIBOR.  In July 2005, we repaid alloutstanding balances on our bank indebtedness using proceeds from the issuanceof the Senior Notes which bear interest at a fixed rate.

 

The following summarizes information concerning ournet positions in open interest rate swaps applicable to periods subsequent to June 30,2005.

 
| ** **                                      | ** ** | **Principal** | ** ** | **Libor** | ** ** |
|-------------------------------------------------|------------|---------------|------------|-----------|------------|
| ** **                                      | ** ** | **Balance**   | ** ** | **Rates** | ** ** |
| Period:                                         |       |          |       |      |       |
| July 1, 2005  to November 1, 2005     |       | $             | 60,000,000 |      | 2.97       | % |
| November 1,  2005 to November 1, 2006 |       | $             | 55,000,000 |      | 4.29       | % |
| November 1,  2006 to November 1, 2007 |       | $             | 50,000,000 |      | 5.19       | % |
| November 1,  2007 to November 1, 2008 |       | $             | 45,000,000 |      | 5.73       | % |

 

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**Item 4 -****  Controls andProcedures**

 

#### **DisclosureControls and Procedures**

#### ** **

Our Board of Directors has adopted a policydesigned to establish disclosure controls and procedures that are adequate toprovide reasonable assurance that we will be able to collect, process anddisclose both financial and non-financial information, on a timely basis, inour reports to the SEC and other communications with our stockholders.  Disclosure controls and procedures includeall processes necessary to ensure that material information is recorded,processed, summarized and reported within the time periods specified in the SEC’srules and forms, and is accumulated and communicated to our management,including our chief executive and chief financial officers, to allow timelydecisions regarding required disclosures.

 

With respect to our disclosure controls andprocedures:

 

•      We haveevaluated the effectiveness of our disclosure controls and procedures as of theend of the period covered by this report;

 

•      This evaluationwas conducted under the supervision and with the participation of ourmanagement, including our chief executive and chief financial officers; and

 

•      It is theconclusion of our chief executive and chief financial officers that thesedisclosure controls and procedures operate such that material information flowsto the appropriate collection and disclosure points in a timely manner and areeffective in ensuring that material information is accumulated and communicatedto our management and is made known to the chief executive and chief financialofficers, particularly during the period in which this report was prepared, asappropriate to allow timely decisions regarding required disclosures.

 

#### **Changesin Internal Control Over Financial Reporting**

#### ** **

No changes in internal control over financialreporting were made during the quarter ended June 30, 2005 that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

32

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##### **PART II.  OTHER INFORMATION**

##### ** **

**Item 4 -  Submission of Matters to a Vote ofSecurities Holders**

 

On May 11, 2005, weheld our Annual Meeting of Stockholders to (a) elect three directors to theBoard of Directors for a term of three years, and (b) advise on the selectionof KPMG LLP as our independent auditors for 2005.  At such meeting, Davis L. Ford, Robert L.Parker and Jordan R. Smith were reelected as directors, and stockholdersadvised that KPMG LLP should be selected as our independent auditors for 2005.

 

The following is asummary of the votes cast at the Annual Meeting:

 
| ** ** | ** ** | **Results of Voting**                       | ** ** | **Votes  For** | ** ** | **Withheld** | ** ** | ** **      |
|------------|------------|---------------------------------------------|------------|----------------|------------|--------------|------------|-----------------|
| 1.         |       | Election of  Directors                      |       |           |       |         |       |            |
|       |       | Davis L. Ford                               |       | 9,655,424      |       | 94,657       |       |            |
|       |       | Robert L. Parker                            |       | 9,509,695      |       | 240,386      |       |            |
|       |       | Jordan R. Smith                             |       | 9,617,193      |       | 132,888      |       |            |
|       |       |                                        |       |           |       |         |       |            |
| ** ** | ** ** | ** **                                  | ** ** | **Votes  For** | ** ** | **Withheld** | ** ** | **Abstentions** |
| 2.         |       | Advisory vote on  the selection of KPMG LLP |       | 9,717,392      |       | 3,532        |       | 29,157          |

 

 

#### **Item 6** -  Exhibits 

 
| **Exhibits**             | ** ** | ** **                                                                                                                                                                                                                                                                                        |
|--------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                     |       |                                                                                                                                                                                                                                                                                              |
| 2.1**                    |       | Agreement and Plan of  Merger among Clayton Williams Energy, Inc., CWEI-SWR, Inc. and  Southwest Royalties, Inc., dated May 3, 2004, filed as  Exhibit 2.1 to our Current Report on Form 8-K filed  June 3, 2004††                                   |
|                     |       |                                                                                                                                                                                                                                                                                              |
| 3.1**                    |       | Second Restated  Certificate of Incorporation of the Company, filed as Exhibit 3.1 to our  Form S-2 Registration Statement, Commission File No. 333-13441                                                                                                                          |
|                     |       |                                                                                                                                                                                                                                                                                              |
| 3.2**                    |       | Certificate of  Amendment of Second Restated Certificate of Incorporation of Clayton Williams  Energy, Inc., filed as Exhibit 3.1 to our Form 10-Q for  the period ended September 30, 2000                                                                                   |
|                     |       |                                                                                                                                                                                                                                                                                              |
| 3.3**                    |       | Bylaws of the Company,  filed as Exhibit 3.4 to our Form S-1 Registration Statement,  Commission File No. 33-43350                                                                                                                                                                 |
|                     |       |                                                                                                                                                                                                                                                                                              |
| 3.4**                    |       | Corporate Bylaws of  Clayton Williams Energy, Inc., as amended, filed as Exhibit 3.1 to  our Current Report on Form 8-K filed with the Commission on  June 1, 2005††                                                                                                |
|                     |       |                                                                                                                                                                                                                                                                                              |
| 4.1**                    |       | Indenture, dated  July 20, 2005, among Clayton Williams Energy, Inc., the Subsidiary  Guarantors and Wells Fargo Bank, National Association, as Trustee, filed as  Exhibit 4.1 to our Current Report on Form 8-K filed with the  Commission on July 22, 2005†† |
|                     |       |                                                                                                                                                                                                                                                                                              |
| 4.2**                    |       | Registration Rights  Agreement dated July 20, 2005, among Clayton Williams Energy, Inc.,  the Subsidiary Guarantors and J.P. Morgan Securities Inc., filed as  Exhibit 4.2 to our Current Report on Form 8-K filed with the  Commission on July 22, 2005††     |
|                     |       |                                                                                                                                                                                                                                                                                              |
| 10.1**                   |       | First Amendment to  Amended and Restated Credit Agreement dated July 18, 2005, filed as  Exhibit 10.1 to our Current Report on Form 8-K filed with the  Commission on July 20, 2005††                                                                               |
|                     |       |                                                                                                                                                                                                                                                                                              |
| † 10.2**            |       | Agreement of Limited  Partnership of CWEI South Louisiana III, L.P. effective as of March 1,  2005, filed as Exhibit 10.1 to our Current Report on Form 8-K  filed with the Commission on April 14, 2005††                                                          |
|                     |       |                                                                                                                                                                                                                                                                                              |
| †  10.3** |       | Agreement of Limited  Partnership of CWEI North Louisiana, L.P. effective as of March 1, 2005,  filed as Exhibit 10.2 to our Current Report on Form 8-K filed  with the Commission on April 14, 2005††                                                              |

 

33

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| †  10.4** |   | Agreement  of Limited Partnership of Floyd Prospect, L.P. effective as of June 1,  2005, filed as Exhibit 10.1 to our Current Report on Form 8-K  filed with the Commission on June 3, 2005†† |
|--------------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                     |   |                                                                                                                                                                                                                        |
| 31.1*                    |   | Certification  by the President and Chief Executive Officer of the Company pursuant to  Rule 13(a) - 14(a) of the Securities Exchange Act of 1934                                                       |
|                     |   |                                                                                                                                                                                                                        |
| 31.2*                    |   | Certification  by the Chief Financial Officer of the Company pursuant to  Rule 13(a) - 14(a) of the Securities Exchange Act of 1934                                                                     |
|                     |   |                                                                                                                                                                                                                        |
| 32*                      |   | Certifications by the Chief Executive Officer and  Chief Financial Officer of the Company pursuant to  18 U.S.C. § 1350                                                                                 |

 

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| *            |   | Filed herewith                                                                                                      |
|--------------|--------|---------------------------------------------------------------------------------------------------------------------|
| **           |   | Incorporated by  reference to the filing indicated                                                                  |
| †       |   | Identifies an Exhibit that  consists of or includes a management contract or compensatory plan or  arrangement |
| †† |   | Filed under our  Commission File No. 001-10924                                                                 |

 

34

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**CLAYTON WILLIAMS ENERGY, INC.**

**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned thereto dulyauthorized.

 

 
|                                        |   | **CLAYTON  WILLIAMS ENERGY, INC.**         |
|---------------------------------------------|--------|--------------------------------------------|
|                                        |   | ** **                                 |
|                                        |   |                                       |
| Date:   August 9,  2005 | By:    | /s/ L. Paul  Latham                        |
|                                        |   | L. Paul Latham                             |
|                                        |   | Executive Vice  President and Chief        |
|                                        |   |  Operating  Officer                   |
|                                        |   |                                       |
|                                        |   |                                       |
| Date:   August 9,  2005 | By:    | /s/ Mel G. Riggs                           |
|                                        |   | Mel G. Riggs                               |
|                                        |   | Senior Vice  President and Chief Financial |
|                                        |   |  Officer                              |

 

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